The Danger of the Real Finanical World

There is a great commentary by Nassim Nicholas Taleb in today's Financial Times (and the whole thing seems to be available, at least I write this, by non-subscribers, so I'd urge you to go quickly and see if it's still up).

Taleb, author of The Black Swan: The Impact of the Highly Improbable is a former trader and risk manager of 20 years experience. In his day, he say many improbably events, culminating in the crash of 1987 (and from what I heard on NPR yesterday, an equivalent sudden drop in market value would be 3000 points on the Dow). His argument is that everyone going through the ranks at business schools is learning modern portfolio theory, an approach to handling risk and investment in which a person or entity handles a mix of investments with varying risk. The concept is that you can plan and diversify your way into financial goals and out of danger. Each asset is a variable, and then you weight the assets, so the value of the portfolio is the combination of those weighted assets. There are expected values of these variables, and expected variances. In theory, you come up with a function that expresses the value of the variable, calculate the variances - how far the value of the variable can be expected to swing - and you can predict the portfolio value.

It's great in theory. However, Taleb points out that this can lead to useless results. Variance depends on historic information, which is fine so long as you recognize the limitation that can impose. (I'd also wonder whether the proponents end up smoothing out data - tossing the scary out-lying values - because it becomes very difficult if not impossible to make calculations with them.) He points to work of mathematician Benoit Mandelbrot, father of fractals, who has tried applying fractal mathematics to the stock market to try and understand the wide swings that happen in short periods, but that probably shouldn't if you use the typical coin toss price goes up/price goes down underpinnings of most stock market prediction. (Here's a Forbes piece on the topic.)

As Taleb writes:

MPT produces measures such as “sigmas”, “betas”, “Sharpe ratios”, “correlation”, “value at risk”, “optimal portfolios” and “capital asset pricing model” that are incompatible with the possibility of those consequential rare events I call “black swans” (owing to their rarity, as most swans are white). So my problem is that the prize is not just an insult to science; it has been putting the financial system at risk of blow-ups.

I was a trader and risk manager for almost 20 years (before experiencing battle fatigue). There is no way my and my colleagues’ accumulated knowledge of market risks can be passed on to the next generation. Business schools block the transmission of our practical know-how and empirical tricks and the knowledge dies with us. We learn from crisis to crisis that MPT has the empirical and scientific validity of astrology (without the aesthetics), yet the lessons are ignored in what is taught to 150,000 business school students worldwide.

Certainly I've seen the 1987 market crash, the dot com meltdown, and more than one major hedge fund collapses (including Amaranth and LTCM, the latter having two Nobel prize winners on its board of directors). Maybe there's something to be said for assuming that the impossible always happens and that current financial models just don't cut it when then meet reality.